A Storm Is Approaching

By Mike DiBiase

Saturday, July 31, 2021
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The summer of celebration is in full swing...

For the most part, we're returning to our normal lives following the COVID-19 pandemic.

More than 160 million Americans are now fully vaccinated against the virus... States and businesses have lifted mask mandates... The number of new cases is down significantly from its peak last winter (though the seven-day average is up slightly in recent weeks)...

Friends and families gathered in neighborhoods earlier this month for Fourth of July parties... Folks are once again crowding into stadiums, cheering on their favorite sports teams... And even though fans aren't allowed due to lingering COVID-19 fears, the world's best athletes have gathered for the summer Olympics in Tokyo.

All the news these days is about how the global economies are getting back on their feet after spending much of the past year in lockdown. Stock markets are hitting new all-time highs. If you're an investor, everything seems rosy... It's worthy of celebration.

The only thing you might be worried about is how fast the rebound is happening... The economy is running too hot, leading to rising prices in many sectors. Still, the Federal Reserve tells us not to worry about that... It assures us it's just a short-term problem.

However, today, I'm going to show you why the storm clouds forming on the horizon of this summer party are worth watching. The good times might continue for now, but as we've learned throughout the years... they don't last forever.

The COVID-19 pandemic has left us with a massive problem in the U.S...

And this problem isn't something the Fed can simply brush aside as "transitory" – like it's trying to do with the recent uptick in inflation.

Specifically, this problem is our country's collective debt load... which keeps growing higher.

I know debt isn't a sexy subject. But if you want to become wealthy, it's important to know about debt... when it can be beneficial... and most important, when it's dangerous.

The first thing to understand is that not all debt is bad. Debt can be a good thing...

In fact, debt can be used to increase a company's earnings per share and return on equity. By using leverage, companies can cause their stock prices to go higher, much faster.

The problem, of course – as with most things in life – is excess...

Too much of a good thing becomes dangerous... The extra leverage brings added risk. When the sun stops shining, the debt doesn't go away. It still must be repaid.

That's exactly what has happened with debt in our country... And the biggest offender isn't who you might first expect. The American consumer has always been the posterchild for our country's long-lasting debt problem. But that isn't the case these days...

Households are actually the most responsible borrowers in the U.S. today...

Americans didn't just use their stimulus checks and unemployment benefits to bid up "meme stocks" like GameStop (GME) and AMC Entertainment (AMC). Some folks acted responsibly and used the money to pay down their credit-card debt and home-equity lines...

Credit-card debt has fallen by 17% since the beginning of 2020. Credit-card delinquencies are now at their lowest level in a decade. And home-equity debt is down 14% since the start of 2020.

This deleveraging has left the average U.S. consumer in much better financial shape than before the pandemic... Total household debt – excluding mortgage debt – is down 2% since the pandemic started, despite tens of millions of people being out of work.

Meanwhile, the biggest abuser of debt these days – by far – is the federal government...

The U.S. now owes more than $28 trillion. This pile of debt represents 129% of our country's gross domestic product. It's the highest this ratio has ever been... It's even higher than it was at the end of World War II.

Since the last financial crisis, the U.S. government's debt has more than doubled, increasing by $17 trillion in that span... And around $5 trillion of this increase has been added since the start of the pandemic.

The U.S. government runs up debt like it doesn't have to pay it back... Last year, it spent nearly twice the amount it collected in taxes, running a $3.2 trillion budget deficit.

Imagine if the average American household behaved like the government...

The median family income in the U.S. is around $69,000. According to the website Federal Budget in Pictures, if the median family managed its budget like the government, it would've spent $132,000 last year and racked up the $63,000 difference in credit-card debt. And that's on top of the $541,000 in debt that the family would've already owed.

Of course, individual Americans don't have the government's luxury of being able to pay back debt by simply printing more money. And neither do corporations. That's why...

Corporate America is in the most immediate trouble with debt...

U.S. companies have simply gorged on debt since the last financial crisis. Corporate debt is up 70% since the end of 2008... It now tops $11 trillion.

This is just an acceleration of a trend that goes back four decades. Corporate debt has increased nearly 1,200% over this period. The reason for this soaring debt is simple...

The Fed has lowered interest rates over and over again during this time period.

Take a look at the chart below, which shows corporate debt and interest rates – measured by the 10-year U.S. Treasury yield – over the past 40 years. As you might know, the 10-year Treasury yield is the most important rate for corporate borrowers. The interest rates they have to pay are based on this rate. That's why I'm using it in this example...

You'd think the Fed was playing a game of limbo... How low can rates go?

Interest rates have steadily descended to zero over the past four decades. And it's pretty easy to see the effects of these changes... Corporations have acted like a bunch of 5-year-old kids set free in a candy store and told to eat as much as they want until they're full.

The pandemic only accelerated this trend...

You'll remember, at the onset of the pandemic last March, the Fed lowered the federal funds rate – the interest rate it directly controls – to essentially zero (to 0.05%). All other interest rates in the economy are based on this rate. The 10-year Treasury yield hit its lowest point ever (0.51%) last August.

On top of having to pay next to nothing on borrowed money, corporations got another gift from the Fed during the pandemic...

Last spring, the central bank began buying corporate bonds for the first time in its history...

This unprecedented move gave the bond market a needed boost of confidence in the middle of the pandemic. More important, it prevented credit from drying up – averting a crisis.

U.S. companies used the Fed's generosity to issue record numbers of bonds last year... Collectively, they issued $2.3 trillion worth of bonds, crushing the full-year record of $1.7 trillion set in 2017. And so far this year, we're on pace to break that record once again...

So-called "investment grade" companies are responsible for around 80% of this borrowing... They're the most credit-worthy borrowers. They can borrow money at lower rates than their less-credit-worthy peers – the so-called "high yield" (or "junk") borrowers – because they are much more likely to pay back their debt.

But investors are even throwing massive piles of money at risky, junk-rated borrowers these days...

For example, junk-rated health care company Centene (CNC) recently sold $1.8 trillion in bonds for a record-low interest coupon of 2.45%. That's the type of rate only companies with clean credit used to be able to get. For example, back in 2016, health care giant Johnson & Johnson (JNJ) – which is one of only two companies with a perfect "AAA" credit rating – issued a bond with a 2.45% coupon.

But that's where we are today... The worst abusers of debt are being treated like royalty. Junk bonds yield an average of just 4%... That's the lowest they've ever yielded. It's even less than inflation today.

And yet, as I'll explain shortly, the risk in buying these junk bonds has never been greater.

If you buy a basket of junk bonds today, more than 4% will almost certainly default. That would turn a 4% return into a guaranteed negative return after factoring in credit losses.

Remember, corporate debt can only go down in one of two ways...

It gets paid back.

Or it gets wiped out in bankruptcy.

In a normal credit cycle, all of the bad debt from the excesses of the cycle gets wiped away... leaving corporations with less leverage. We saw deleveraging after the last financial crisis. But not this time...

The pandemic caused 146 U.S. companies to default on their debt last year, according to credit-ratings agency Standard & Poor's. But that wasn't nearly enough to wipe away all of the bad debt.

Corporate debt hasn't fallen... It has done the opposite, growing faster and higher than ever before.

And much of this corporate debt will never be paid back...

How do I know? Just look beneath the surface and you see all sorts of risks...

For example, the credit quality of corporate debt is much worse than ever before.

The percentage of corporate borrowers with junk credit ratings is now at an all-time high (58%). In other words, nearly six out of every 10 borrowers in the U.S. have dubious credit ratings. These are the borrowers who are much more likely to default.

The same deterioration is evident in the highest-rated borrowers, too... Today, 55% of all investment-grade borrowers are on the lowest rung of the ladder before dropping into junk territory (credit rating of "BBB"). These borrowers are one downgrade away from becoming junk credits.

Before the pandemic, that percentage was less than 50%. And before the last financial crisis, it was less than 30%. So as you can see, the problem is getting worse across the entire credit spectrum.

The truth is, even with record-low interest rates, many companies these days can't even afford to pay the interest on their debt...

The Fed has created a nation of corporate 'zombies'...

Zombies are companies that don't earn enough profits to cover their interest – let alone repay their debt. They're the walking dead, only kept alive by creditors willing to lend them more money to pay off their debt as it comes due.

Zombie companies are now at an all-time high. The current mark of 24% far eclipses the previous record of 16%. Take a look at how much it has surged in recent years...

Think about that... One out of every four companies is a zombie. They're only alive today because the Fed has consistently lowered interest rates, allowing them to keep kicking the can down the road.

But now, the Fed has painted itself into a corner...

With interest rates near zero, the Fed can't lower them any further. And with inflation rising, it can't afford to keep them low much longer. Soon, it will be forced to raise them.

The problem is that it can't afford to raise them very far either... If it does, the cost of the debt will be too much for many borrowers to handle. Higher rates will set off a wave of bankruptcies like we've never seen before.

Edward Altman believes we're on the cusp of that happening. And if anyone would be qualified to know, it would be him...

The New York University professor invented the best predictor of corporate bankruptcies in 1968 – the famous "Altman Z-score." He believes we're headed for a second wave of bankruptcies beginning this year.

Fortunately, this wave of bankruptcies is nothing to fear – if you're prepared for it...

You can make massive returns when it does happen by buying corporate bonds.

If you've never considered buying corporate bonds, hear me out... Unlike stocks, bonds are the legal obligations of companies. That makes them much safer to own than stocks. Companies must pay their bond investors no matter what's happening in the economy or the markets.

Here's why you should consider investing in corporate bonds...

When the next credit crisis arrives, many corporate bonds will get much, much cheaper. As bankruptcies begin to soar, investors will want nothing to do with corporate bonds. You'll be able to buy some of them for pennies on the dollar – even the safe ones.

And the less you pay for these bonds, the more money you'll make.

That's because the companies that issued these bonds are legally obligated to pay you the full principal of the bonds at maturity regardless of what you paid for them. You'll earn interest as well as potentially large capital gains – as much as 100% or more.

These investments allow you to build your wealth when everyone else is losing money. Buying safe corporate bonds at huge discounts is a strategy that the world's wealthiest investors use in times of crisis.

Some of the world's greatest investors wait for moments like this... billionaires like Warren Buffett... John Paulson... Paul Singer... Andy Beal... Sam Zell... and Wilbur Ross. These guys do the exact opposite of most investors.

While everyone else is chasing prices higher in the late-stage bull market euphoria, these billionaires are busy raising cash.

Then, when the crisis unfolds, they pounce. They use a little-known type of investment – a type of corporate bond called a distressed bond – to make more money than you ever thought possible.

My colleague Bill McGilton and I recommend discounted corporate bonds in our Stansberry's Credit Opportunities advisory...

While we've yet to see a full-blown credit crisis since launching our newsletter back in 2015, we've still done very well... We've closed 49 positions (with an 86% win rate) for an average annualized return of 18%.

That's more than double the return of the 8% overall junk-bond market, as measured by the largest corporate-bond exchange-traded fund, the iShares iBoxx High Yield Corporate Bond Fund (HYG). It almost beats the stock market's 21% annualized return over that span, too... And keep in mind that we're doing it with legally protected, much safer investments.

Our strategy works best during a credit crisis...

That's when the high-yield spread soars to more than 1,000 basis points ("bps"). The high-yield spread is the difference between the average yield of junk bonds and the yield of similar-duration U.S. Treasury notes.

This spread briefly spiked to more than 1,000 bps last March. And in Stansberry's Credit Opportunities, we seized the opportunity... The eight bonds we recommended between March and May 2020 produced an average annualized return of 59%.

The chart below shows our publication's performance over various periods versus the bond market (as measured by HYG) since launching our newsletter about six years ago...

You can see that when the high-yield spread spikes, our returns soar.

We believe the spread will spike once again when the Fed is forced to raise interest rates in response to rising inflation. And we're ready to strike when the opportunity arises.

We'd love for you to join us. But you don't just have to take our word for it...

A couple of years ago, one of our own paid-up subscribers contacted us with an unusual request... He wanted to go on camera to share his personal experience with our strategy.

So of course, we let him...

We guarantee you won't want to miss what he said. Plus, as you'll see, we've arranged an incredible offer for this research as part of our agreement with him. Get all of the details here.

Regards,

Mike DiBiase
July 31, 2021

Whitney Tilson

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About Berna

Berna Barshay is editor of Empire Financial Daily and a contributing editor to the Empire Stock Investor and Empire Investment Report newsletters.

She graduated cum laude from Princeton University and earned her MBA from Harvard Business School in 1997.

Following her graduation, Barshay spent 20 years on Wall Street. She began her career in equity derivatives at Goldman Sachs and later worked as a buy-side equity analyst at Sanford Bernstein, where she covered global consumer cyclicals and conglomerates.

Later, Barshay spent five years working as a portfolio manager of the Ingleside Select Fund, a long/short fund with a focus on value and event-driven stocks. She later was a portfolio manager at Swiss Re, where she managed the Consumer long/short book on the equity proprietary trading desk.

She has additional experience as a buy-side analyst at several long/short hedge funds – including Sky Zone Capital, Metropolitan Capital, Buckingham Capital, and LaGrange Capital – where she primarily covered consumer and technology, media, and Internet stocks in the U.S. and Europe, with some additional work in financials and energy.

Barshay is a fashion enthusiast, a pop culture addict, obsessive indoor cycler, and prolific social media user. She currently lives in New York with her husband, daughter, and three dogs.